Derivatives are immensely complex financial instruments that are deeply intertwined in the global financial system. These complex instruments have generated a lot of wealth for financial experts and companies that have made the right “bets.” They have also caused huge losses for those who have bet wrong.
In a true free market if a financial company makes too many bad bets they would be allowed to go bankrupt, but in an era of “too-big-to-fail” financial companies, governments have been forced to bail out numerous financial companies who have made bad bets on derivatives. Does this loss of the “survival of the fittest” mechanism create enough of a risk to warrant increased oversight and regulation within the derivatives market?
Derivatives are essentially “side-bets.” They are contracts drawn up between two or more parties outlining specific conditions under which one party must pay another. That vague definition pretty much sums it up, but think of what it really means.
If you and your friend Billy make a bet on a football game over which team will win, you are essentially writing a derivative. The conditions are specified; each person choses a team; the teams play the game; the person who chose the winning team is paid by the person who chose the losing team. People making bets on sports games don’t write an actual derivative of course, but the principles are similar.
Financial managers will claim, of course, that derivatives are not being written based on luck and chance or uneducated guesses. Instead derivatives are written by by highly-knowledgeable and well-trained financial experts who are analyzing “risk” and trying to spread this risk among interesting parties. These other parties are likewise employing highly-trained experts who know precisely what they are doing.
Yet if the 2008 Financial Crisis proved nothing else it proved that many of these so-called experts and banks had no idea what they were doing. Many financial companies reaped huge profits off derivatives. Others lost billions of dollars and needed to be bailed out.
The question we need to ask ourselves is if it’s appropriate or wise to let banks continue to make these opaque and complex bets concerning our economy. In a truly free market it would be no one’s business except for the people making the bets. If a bank bets bad, they lose money and if necessary would close down. The reality is more complex, however, as many financial companies and other companies are simply “too big to fail.” If JPMorgan Chase & Co. (NYSE:JPM) or Goldman Sachs Group, Inc. (NYSE:GS) suddenly went bankrupt the fallout could potentially destroy the global economy.
And this is precisely what happened in the 2008 Financial Crisis. Insurer American International Group, Inc. (NYSE:AIG) made numerous bad bets and bankruptcy was imminent. The United States government realized, however, that a complete collapse of American International Group, Inc. would likely send the world into a full-blown depression. So the government stepped in with some 85 billion dollars in aid and essential took ownership of the company.
This creates non-functioning market in which risk is now socialized by “too-big-to-fail” banks that recognize that they are simply too big to fail. If a major financial company bets well they will reap all of the profits. If a financial company bets bad, a government will have to step in and bail them out or else risk ever worsening economic conditions. In such a marketplace why wouldn’t banks make exceptionally risky bets? Remember, the greater the risk, the greater the potential reward. If they win, they win. If they lose, the taxpayer will have to bail them out.
Should governments continue to let the derivatives market remain largely unregulated with almost no oversight and little transparency? Or does the circumstance of socialized risk warrant enough of a threat to the global economy to justify increased regulation and oversight? Given the risks posed to Global Society as a whole, I would argue that there is indeed enough justification to regulate the global Derivatives market or else break up financial companies to ensure that they are not too big to fail.